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U.S. prison investors may be rewarded if they keep their nerve

(Reuters) - Investors in U.S. privately owned prisons may be rewarded if they keep their stocks given sector watchers have said presidential candidate Hillary Clinton would have difficulty realizing her goal of doing away with for-profit detention.

Shares in Corrections Corp of America (CXW.N) fell 7.4 percent and GEO Group Inc (GEO.N) stock dropped 3.8 percent on Tuesday after Clinton said during Monday night's debate with rival Donald Trump that she wants U.S. states to stop using private prisons and that there should not be a "profit motivation to fill prison cells."

This came on the heels of a U.S. Justice Department announcement on Aug. 18 that it would phase out its use of privately operated prisons, a move that Hillary commended. It also follows an Aug. 29 promise by the Department of Homeland Security to review whether it will keep using for-profit detention centers.

But if Clinton is elected, her goal faces roadblocks such as overcrowding in government-owned prisons and the fact that the federal government does not oversee state prisons, said Eric Marshall, portfolio manager with Hodges Funds in Dallas.

"Saying you're going to do this is good to get elected but the math doesn't work," said Marshall whose firm owns GEO and Corrections shares.

Hodges cut its exposure to GEO when its shares traded at $30 as Marshall said he expected volatility driven by political criticism of for-profit prison use. But the firm bought the stock again after it fell to $18 on Aug. 18, according to Marshall who said it became "very attractive."

Hodges also owns a smaller amount of Corrections Corp shares, according to Marshall who did not disclose ownership numbers.

GEO shares fell as low as $23.33 on Tuesday but were still above their Aug. 18 close of $19.51. Corrections Corp shares fell to $14.65, their lowest level since Aug. 18 when it plummeted 35 percent in a day at closed at $17.57.

After the closing bell on Tuesday, Corrections Corp said it would lay off up to 55 headquarters staff, but a statement announcing the move did not associate the move with the Obama administration moves. It employs more than 14,000 staff.

If the government reduces occupancy of private prisons, which house 25 percent of the federal prisoner population, prison companies will require it to pay more per prisoner, according to Marshall. If it rents facilities from private companies, operating costs will be prohibitively expensive partly because government prison guards earn more, he said.

"The reality is that governments want to build schools, hospitals roads, bridges ... They don't want to spend billions of dollars on prisons," said Marshall. He estimates that it would cost $120 million to build a prison for 2,000 inmates.

Some bondholders also appear determined to hold on.

Ryan Jungk, credit analyst at Newfleet Asset Management, said Corrections Corp bonds were still attractive since there was no viable alternative for states to cancel their contracts with private prison operators absent major prison reform. He said political risk was also embedded in the bonds' prices.

"The risk has definitely gone up and the rhetoric has gotten worse both from Obama and Hillary Clinton, but I think that the current pricing reflects that, and you’re rewarded for taking that risk," he said.

Jungk said prices on the company's bonds, currently at 93 cents on the dollar, could rise to 98 cents, while the 5 percent interest coupon also made them worth holding. Newfleet sub-advises the Dunham Corporate/Government Bond Fund, which last had about 0.2 percent of its assets in Corrections Corp bonds, according to Lipper data.

Canaccord Genuity analyst Ryan Meliker said both stocks are risky short-term bets as he expects volatility as long as private prison use is a political focus ahead of the Nov. 8 election. But he sees GEO shares reaching $28 by the end of 2017 and says Corrections Corp to get back to $21.

For example if the political focus changes to the age of publicly owned prisons, this would be good for private prisons. Meliker prefers GEO which he rates 'buy'.

"Long-term investors should buy. Near term you've got a lot of headline risk," said Meliker who said that Corrections Corp, which he rates 'hold' is vulnerable to policy changes that could affect its Oklahoma and Texas facilities.